No trader likes to give up the edge and nowhere does that seem more valid than in the futures industry. z After almost a decade of sensational announcements, quiet failures and some $100 million in development costs, electronic order entry, execution and price reporting during daytime trading hours is now a reality at Chicago's futures exchanges.
The Chicago Board of Trade (CBOT) in September, and a year earlier, the Chicago Mercantile Exchange (CME), have now implemented electronic trading on a total of three contracts during normal daytime business hours. This is a departure from past practices that allowed electronic trading only after open outcry's daytime hours ended.
While announcements about electronic futures trading have been made many times before, the fact that both Chicago exchanges, which account for about 75% of the nation's trading volume, are now offering modest electronic access is considered historic. That's because screen trading during daytime business hours has always been considered a frontal assault on the income-producing abilities of the floor traders who own the exchanges.
As a result, Chicago floor traders considered electronic access to pit-traded contracts the Trojan Horse of the industry. They may be right. In two dramatic developments, that point was driven home recently. The Deutsche Terminbourse (DTB) successfully captured the German Bund contract from its initial home at the London International Futures and Options Exchange (Liffe) by trading it electronically. Across the Channel, the French Matif started side-by-side open outcry and screen trading of its contracts. Within a few weeks, open outcry was dead. "When screen trading comes, it wins," says Clark Heston, director of the Risk Management Center of Chicago.
As a result, international competition - some of it propelled by the lower costs and faster access attributable to screen trading - has cut into the combined market share of both Chicago exchanges over the past decade. In 1998, combined market share fell to 23%, from 38% in 1988.
These points have not been lost in Chicago. The introduction of screen trading is one reason why seat prices at both Chicago exchanges plummeted this summer to about 50% from their 1997 peak of $857,000 at the CBOT, and to about one-third of their top price of $925,000 at the CME.
reasons for change
While both Chicago exchanges now offer modest electronic access, each had a different reason for doing so. The CME started trading its electronic E-Mini S&P futures contract (one-fifth the size of the S&P 500 Index future) on Sept. 9, 1997, to appeal to retail futures traders who could enter their trades via the Internet through their trading firms. But to preserve the profitability of the S&P 500 futures trading pit, large trades entered on the E-Mini are flagged by pit personnel and traded by open outcry.
What forced the CBOT's hand into its electronic makeover was the start of trading in an entirely new electronic futures venture, the Cantor Fitzgerald Financial Futures Exchange (CFFE), a co-venture between the former New York Cotton Exchange (now the New York Board of Trade) and Cantor Fitzgerald Inc., the world's largest cash bond dealer.
Few times in the history of this insulated business has a new venture caused as much consternation. That's because the CFFE allows a number of innovations: Both cash bonds and futures can be seen on over 100,000 screens of Cantor's clients worldwide in a more competitive and cheaper trading environment. By the end of this year, the CFFE also plans to allow its customers direct access from their trading desks without going through any intervening personnel. Further, the new exchange's initial product is a direct frontal assault on the CBOT's biggest contract, U.S. Treasury Bonds.
The CFFE system opened Sept. 8. Not to be outflanked, the CBOT's screen trading of financial futures was pushed to a membership vote and started trading Sept. 28 on some 400 screens. And earlier, in an apparent retaliatory move, the CBOT voted to screen-trade all the futures contracts traded by the former New York Cotton Exchange, the exchange that has partnered with the CFFE.
Yet while the CBOT was forced into offering daytime electronic trading, the exchange's allegiance is still with open outcry. Commissions for electronic trading via the CBOT's Project A system is "significantly more expensive" than open outcry execution, according to a CBOT spokesman. For pit trading the cost is 1 1/2 cents per side (3 cents a side for a member), and $1 a round-turn for non-members. Costs for Project A trading are 3 cents a round-turn, plus an additional CBOT fee that can range from 10 cents to $1.50 per side, depending on the type of trader who enters the trade.
Partly as a result of this structure, the CBOT spokesman says the exchange believes customers will choose open outcry, "since that is where more trades, and lower commissions, will occur." But that has not been the case at other exchanges.
When the DTB and the London International Financial Futures and Options Exchange (Liffe) were trading the German Bund contract, the DTB set its clearing fees significantly lower than its competitor to gain a larger market share. According to Larry Arnowitz, chief executive officer of GNI Inc., the US subsidiary of GNI Ltd., a large European broker, the lower fees helped build the needed trading volume. Eventually, the Liffe lost the Bund contract to the DTB.
Trading overhead should also play a role in how the CBOT shapes the outcome of its side-by-side trading experiment. That's because CBOT customers benefit by paying lower execution fees to a pit broker than comparable trades done electronically, Arnowitz added. For instance, a CBOT pit trader is paid about $1 to fill a trade, but less on Project A. "Traders usually go to where the liquidity is," Arnowitz says, "but with this structure, it looks like the liquidity will stay in the pit regardless of the merits of Project A vs. open outcry."
Large futures money managers also are watching the introduction of daytime electronic trading. Patrick Welton, president and chief executive of Welton Investment Corp., a Carmel, Calif., commodity trading advisor with about $300 million under management, says he is "optimistic that electronic trading, if properly implemented and exposed, has the potential to significantly increase market liquidity by overcoming the physical constraints of a trading pit. But the keywords here are 'properly implemented.'"
exchanges facing structural changes
The introduction of side-by-side screen trading sets the stage for exchanges to be confronted by larger issues, including some that could challenge their management structures.
"The CBOT has a great franchise, great traders, and they should be able to keep their top position. But they have to restructure, otherwise they may go down in history as a classic case of letting your franchise disappear if they do not act properly and face the challenge of electronic trading," says Ray Cahnman, chairman of Transmarket Group Inc.
Cahnman, an active proponent of Project A, says the CBOT has to understand that the CFTC has sent the signal, by expeditiously approving the CFFE application, that they want screen trading in all contracts, including eventually the grains. "Technology is not standing still. And if there are any problems now, they will be solved soon," he says. "When we get voice recognition technology, anyone can be in the virtual electronic pit and you can trade from anywhere, as well as execute more complex strategies."
Cahnman was more upbeat, however, about how floor traders can add liquidity to an electronic trading system. On Project A almost every commercial order is tagged with a local on the other side, with "very few" commercial orders traded with each other, according to Cahnman. "The locals pay a lower fee, so they essentially have an incentive to be on the system at all hours. If the tick sizes are reduced, as I think they will be, that would encourage more incremental trading, and tighter spreads. That makes a better market."